The pound gained on international currency markets yesterday, moving up just over 1p to 91.4p sterling and one cent stronger against the US dollar at $1.4440.

The rise in the pound came in the slipstream of heavy selling of sterling as investors moved into the deutschmark. The move away from sterling and the dollar into the deutschmark followed a warning from the Bundesbank that it would not hesitate to raise interest rates to curb inflation. Sterling was not helped by the indication from the Bank of England in its quarterly report that British interest rates would remain unchanged for now.

The pound slipped against the deutschmark, closing about 11/2 pfennigs weaker at DM2.6550 and 10.7 per cent above the weakest currency in the EU Exchange Rate Mechanism. With its improvement against sterling and fall against the deutschmark, the pound is moving in the direction that the Irish authorities want and a direction that reduces the likelihood of a revaluation.

Early in the day, sterling shrugged off robust employment data, with a drop of 49,800 in July unemployment against an expected fall of 30,000. But the currency then fell over four pfennigs to reach a four-month low, dropping through the significant DM2.90 level to DM2.8930. It recovered slightly late in the day to close at DM2.9020.

The Bundesbank sounded alarm bells on monetary policy yesterday, making clear it was scrutinising a recent upturn in inflation and would not hesitate to tighten its policy if warranted. In its August monthly report, the bank said: "It cannot be overlooked that there has been a stronger rise in consumer prices in the last few months. . . . The Bundesbank will orientate its policy in such a way that price stability, which has been essentially achieved, can be maintained."

The comments landed in financial markets already dominated by expectations that a German interest rate rise - signalling the end of five years of easier policy - is in the pipeline. The deutschmark gained in response to the comments and German bonds and shares slipped back.

"We had been expecting an increase at the end of the year," Paribas Capital Markets economist, Mr Marco Kramer said. "We now think there will be an interest rate rise in the next three months," he added.

Recent sharp slides in the deutschmark had been seen by markets as the main reason spurring the Bundesbank to action. The dollar has gained about 20 per cent against the deutschmark this year despite repeated warnings along the way that it had risen far enough.

But the new element of tough talk on inflation puts the speculation into a completely different category. The Bundesbank regularly stresses that it does not follow an exchange-rate-oriented policy but rather sticks religiously to its main task of defending the price stability of the deutschmark, changing its policy when justified on domestic grounds.

In interviews published last week, the central bank's chief economist, Mr Otmar Issing, had pointed to high capacity utilisation and price pressures at various levels of the economy. Yet economists believe an immediate move is unlikely, gambling that the price pressures within the economy would have to gain strength before eliciting a response.

Annual inflation hit a 25-month high of 1.9 per cent in July, but was distorted higher by special factors.

The central bank refrained from adjusting its main money-market rate, the repo, this week, leading financial markets to expect no policy change until the Bundesbank council resumes regular meetings on August 21st, after the summer break.

In its report, the Bundesbank repeated recent comments that it was watching the currency markets closely, linking this firmly to the potential influence of deutschmark losses on prices.

"The Bundesbank will observe further currency rate developments closely with a view to the risks presented for price stability," it said. A weaker currency holds the risk of imported inflation as import prices are boosted.

In its authoritative Quarterly Inflation Report yesterday, the Bank of England warned that there was still a risk the government would miss its inflation target in two years' time - despite the four recent rate rises. The Bank said its central forecast was that the target of 2.5 per cent would be achieved, but added that the risks were "on the up side".

However, interest rates are likely to remain on hold for the time being as the Bank said it was time to "take a pause to assess the risks".

The central bank forecast is lower than that given in the May quarterly report and the bank said the outlook for inflation was "favourable".